Vijay Kumar Gaba

The US Federal Reserve Open Market Committee (FOMC) decided to hike the key federal fund rate by 25bps to 4.75% - 5% range. This is the eighth straight hike decision by the FOMC since the Fed started its fight against inflation in March 2022; bringing the rates to highest since September 2007.

Speaking to the press post FOMC meeting, the Fed chairman Jerome Powell, dismissed the speculation about any imminent rate cuts, stating “FOMC participants don't see rate cuts this year, it is not our baseline expectations”.

The post meeting statement of FOMC indicated that the policy may remain sufficiently restrictive though future hikes shall be data dependent. The statement read “The Committee anticipates that some additional policy firming may be appropriate in order to attain a stance of monetary policy that is sufficiently restrictive to return inflation to 2 percent over time” and “The Committee will closely monitor incoming information and assess the implications for monetary policy”.

The market participants interpreted the statement to imply that at least one more rate hike of 25bps will be done this year, before the Fed hits a pause button.

Powell emphasized that the Fed is “committed to restoring price stability, and all of the evidence says that the public has confidence that we will do so.” Speaking about the recent banking sector crisis, the chairman assured that “US banking system is sound and resilient” and the Fed is “prepared to use all of its tools to maintain stability.” He however admitted that recent banking turmoil is “likely to result in tighter credit conditions for households and businesses, which would in turn affect economic outcomes.”

The Fed maintained that the current pace of quantitative tightening (QT) shall continue, though recent emergency measures to mitigate the impact of the banking crisis have resulted in expansion of its balance sheet.

The US equities ended the session with a cut of 1.6%; while US dollar index 9DXY) lost 0.7%.

 The Reserve Bank of India made its last policy statement of 2022 on Wednesday, 07 December 2022. The next policy statement of the RBI is scheduled in February 2023.

 “Higher interest rates, slower growth and a softening labor market are all painful for the public that we serve, but they’re not as painful as failing to restore price stability and having to come back and do it down the road again.” – Jerome Powell, Chairman of the US Federal Reserve

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) decided to hike the policy rate by another 75bps taking the federal fund rate to 3.0%-3.25% range; the highest level since 2008.

In the post meeting press statement, the Fed chairman Jerome Powell reiterated Fed’s commitment to bring down the inflation to its target level of 2%. The Fed officials indicated that the Fed would keep hiking rates further till the terminal rate of 4.6% is reached next year. This implies another possible 75bps hike in November, followed by a couple of smaller hikes in the two subsequent meetings. Quelling the market expectations of a cut next year, the fed officials hinted that no cut is seen in 2023.

Six of the nineteen FOMC members even see the terminal rates at 4.75%-5%, implying a 175bps further hike till 2023 end, before the Fed begins to scale down in 2024, bringing the rates back to below 3% only in 2025.

It is pertinent to note that there is no precedence of Fed hiking so aggressively since 1990 when the overnight funds rate was adopted as its primary policy tool. In 1994, Fed had hiked 2.25%, resorting to cuts the very next year. US Inflation had probably peaked at 9.1% ( CPI, yoy) in June, before easing to 8.3% in August.

Indicating a recession-like condition in 2023, in their quarterly estimate of rate and economic outlook, FOMC stated that unemployment rate may rise sharply to 4.4% in 2023 from the present 3.7%. FOMC scaled down its estimates for economic growth in 2023 to 1.2% and 1.7% in 2024, reflecting a bigger impact from tighter monetary policy.

From this month, the Fed has also accelerated its quantitative tightening program with US$95bn/month reduction in its US$8.9trn balance sheet.

The Fed decision did not bring any surprise for the market, as the consensus was for a 75bps hike, with a minority expecting even a 100bps hike.

·         The US benchmark indices ended the day with sharp cuts after a highly volatile session.

·         USD Index (DXY) strengthened to over 111, its highest level since April 2002.

·         Industrial metals and crude ended with over 1% cut, while Silver (2.2%) and Gold (0.6%) were higher. Bitcoin lost over 2%.

·         Bond markets quickly priced in the growing risk of a recession as the Treasury yield curve further inverted. The 2-year treasury yield over 10-year Treasury yield inverted to beyond 50-basis points.

Indian markets are also expected to open with a cut of about 1%.

 In a recent research report, Goldman Sachs estimated that “energy bills will peak early next year at c.€500/month for a typical European family, implying a c.200% increase vs. 2021. For Europe as a whole, this implies a c.€2 tn surge in bills, or c.15% of GDP.” The bank believes that repercussions of this “will be even deeper than the 1970s oil crisis.” Obviously, a problem of the magnitude would require an impactful policy intervention that could have wider and deeper implications for decades to come.

The policy interventions could involve partial suspension of free market mechanism; rationing of energy consumption; fiscal subsidies; deferment of climate goals and increased use of coal and/or accelerated shift to renewable sources of energy etc. Besides, there could be serious geopolitical implications also.

In another interesting paper, McKinsey & Co, outlines how inflation may be flipping the global economic script. In the paper McKinsey’s experts have examined many of the strategic implications of inflation. The key points highlighted in the paper could be summarized as follows:

·         In the past six months, inflation has far exceeded December 2021 expectations. In many countries, actual rates have doubled projections. European countries are particularly affected. Asia is seeing a less severe change: Indian inflation is about 7 percent, only a bit above projections; and South Korea is at 5 percent. In China and Japan, inflation remains muted.

·         In response to inflation’s alarming rise, central banks worldwide are raising their core bank lending rates. So far, however, rate raises in most countries have not matched the pace of inflation. The rising rates are expected to ease demand and lower prices for two critical components of headline inflation: housing and commodities such as energy and metals.

·         The lift-off in fertilizer prices, supply chain snags, drought, along with other fallout from the war in Ukraine, has pushed prices for basic foods much higher. Since 2021, food prices have risen to their highest level since the United Nations’ Food & Agriculture Office began its index. Prices today are considerably higher than in past surges in 2008 and 2011.

·         As economies stabilized and reflated post Covid, real wages began to creep higher again. But rampant inflation checked that growth, rising so fast that it has diminished the purchasing power of people’s take-home pay. For example, workers in the United Kingdom today have seen their real compensation fall by roughly 8 percent year-on-year.

·         As prices soar, and show few signs of abating, the risk is that inflation becomes entrenched and central banks will have to raise rates more assertively to slow demand. The growth may slow down much more than previously estimated.

The global economy is therefore entering a prolonged phase of correction and realignment. For many these corrections may be extremely painful, while for some it could provide an opportunity to enhance their position in the global order. India, being one of the least impacted countries in this global turmoil, hopefully would fall in the latter group. Amen!

 In the current year 2022, inflation in India has consistently remained above the RBI tolerance band of 2-6%. For the month of August Consumer Price Inflation (CPI) was 7%, led primarily by the food inflation of 7.6%. Both rural and urban inflation recorded a MoM rise in August. Unfavourable weather conditions apparently led to sharp rise in the prices of vegetables, fruits, spices etc. However, the core inflation (CPI ex food and fuel) has also persisted over 6% since the past many months; emphasizing the persistent pricing pressures. The IIP growth in July also moderated to 2.4% led primarily by consumer non-durables – indicating pressure on household finances. The sharp rise in household debt, especially the expensive credit card rolling credits, also corroborates the rising stress on household finances.

In view of the elevated price pressures, the Monetary Policy Committee (MPC) of RBI is expected to keep raising rates in line with the global peers. The market consensus is expecting the policy repo rate to rise to 6% (currently 5.40%) by the end of 2022. In his latest statement, the RBI governor stated that he does not expect moderate hikes in policy rates and elevated prices to hurt the growth materially and the economy may still retain the momentum to grow 7% in FY23.

The RBI estimate of growth may be optimistic in view of the poor Kharif crop estimates; challenges to exports; rising interest cost and poor consumption growth outlook. The risk of a global energy crisis in winter is also looming large and could have some negative implications for our inflation and growth outlook.

Inarguably, the claim of the finance minister that India faces zero chance of a recession is tenable. But a growth of 5-6% on a low base would be nothing to celebrate in our circumstances.

Obviously, the financial markets are disregarding the macroeconomic conditions and focusing on micro opportunities, especially the ones driven by policy impetus. In particular the following are some identifiable drivers of the stock markets in the recent up move.

1.    Strong emphasis on enhancing local defence procurement, especially in view of the global sanctions on our largest supplier (Russia) and elevated Chinese threat. The global sanctions on Russia have also presented an opportunity to Indian manufacturers to gain some foothold in global defence equipment and missiles markets; where the efforts of Indian entities, made in the past many decades, have started yielding results. The stocks of the companies that could be potential gainers from higher local defence procurement are favourites of investors as well as traders.

2.    Realignment of global supply chains in the post Covid world is expected to trigger a new capex cycle in Indian manufacturing sector. The potential beneficiaries of this capex cycle like capital goods manufacturers are also gaining traction with market participants.

3.    The most favourite sector in Indian markets is the financial sector. The cleaned up balance sheets after years of efforts and increased margins as the rate cycle turns up are attracting massive investor interest to the sector.

4.    The energy crisis in Europe and the US is also creating opportunities in Indian markets. For example, prohibitively higher energy cost has rendered significant industrial capacities (especially in high energy consuming sectors like chemicals) unviable. Closure of these capacities is allowing some Indian manufacturers to gain market share as well as better pricing power.

5.    The trends in energy security and climate control (green energy, electric mobility etc.) are also leading greater investor interest in the related businesses.

6.    Given the poor growth outlook in Europe and China, the FPI flows have turned towards emerging markets like India. Significant positive flows over the past couple of months have also helped Indian equities to outperform its global peers.

It seems the divergence between the equity market performance and macroeconomic conditions may continue or even widen in the short term. However, over a longer period, say 12-15 months, both invariably converge. Till then its happy times for the investors and traders.

It is a basic human tendency to long for what they do not possess. It is common to find people who have struggled very hard to achieve certain goals; but almost instantly feel dissatisfied with (or indifferent to) the outcome. They either realize that it was not something they actually wanted in the first place; or they immediately shift the goal post and begin to struggle/strive for a different/higher goal. This basic human tendency, that often manifests in a constant need to move, evolve and grow, is at the core of all economic growth and development. And perhaps this is the key factor that undermines the issue of sustainability.

Metaverse is nothing but a realization that humans never wanted to globalize in the first place. They like to remain confined to their caves and tribes. It was perhaps the starvation and disease that would have forced the first tranche of immigration.

Of course since the end of the stone age, this realization has taken more than 5000 years; many rounds of polluting industrialization; chopping of billions of trees; extinction of many species; killing of millions of people in wars, to dawn upon the mankind. And it may actually not be the full circle and we may still want something more once we realize the goal of living in a predominantly virtual world.

If I may put this hypothesis in a more recent context-

·         The people of USSR were sick of the central command economy and wanted a democracy that facilitates their participation in the global growth and development; besides making the governance structure transparent, corruption free and progressive. Gorbachev gave them an opening to the world they were struggling to live in. In less than two decades, they chose to hand over the power to an authoritative leader who is not even committed to any socio-political ideology; aspires to restore Tsarist colonial ambitions and cares least for the global order, transparency and accountability.

·         China, which has consistently supported Pakistan’s demand of self determination by Kashmiri people at all global platforms, refuses the same rights to the people of Tibet and Taiwan. The Chinese authorities and businesses demand equal rights for their companies from the governments of foreign jurisdiction where such Chinese corporations have established operations. However it refuses to allow similar justice and freedom to its own corporations and entrepreneurs like Jack Ma.

·         We find that for almost a decade the central bankers of the developed world struggled to create inflation and full employment in their respective economies. When the inflation finally occurred, it is now their biggest problem.

·         The farmers, agriculture experts and politicians in India clamored for farm sector reforms for many decades. But when a significant part of these reforms were delivered, people launched a movement for reversal of these reforms.

·         The industrialists and financial market participants long for accelerated economic and fiscal (tax) reforms. However a mere mention of withdrawal of Income Tax exemptions and concessions (e.g., LTCG) makes them apprehensive.

The simple point is that the investors should not get passionately attached to a new trend or event. Most of these could be ephemeral; and could evaporate as soon as these go out of media headlines.

Some notes on the current state of the Indian economy.

Monsoon ‘abnormal’ so far

The monsoon season this year has been quite erratic so far. Statistically, during the period from 1^st June to 22^nd August the country has received 9% more than the normal rainfall. However, the temporal and spatial distribution of rainfall has been quite abnormal so far.

·         252 (36%) of the 703 districts in the country have witnessed ‘excess’ (20% to 59% above normal) to ‘large excess’ (60% or more above normal) of rains.

·         236 (34%) districts have received ‘normal’ (upto 19% above or below normal) rains.

·         215 (30%) districts have received ‘deficient’ (60% to 59% below normal) to ‘large deficient’ (more than 60% below normal) rains.

·         More importantly, the granaries of India – UP, Bihar, Jharkhand, West Bengal have been mostly deficient to large deficient. In UP, 66 out of 75 districts have been deficient to large deficient. In Bihar 35 out of 38 districts have received deficient to large deficient rainfall.

The agriculture activities have been affected in large part of the country due to erratic, large excess and deficient rainfall. However, the water storage levels in most reservoirs are now good and soil moisture is also better, which augurs well for the Rabi crop. Thus, despite a below par Kharif crop and poor summer vegetable crop; we may see decent overall agriculture growth in FY23. However, the rural demand in this festival season may be not buoyant. The rural credit may also face renewed stress in some pockets.

Infrastructure orders ‘strong’

NHAI reportedly awarded 6,306km of orders in FY22 – vs 4,788/3,211km in FY21/20, exceeding its target of 5000km. Other government departments and state governments are also accelerating the pace of infra order awarding, especially in roads, irrigation, metro, water and mining. It is expected that the order momentum may sustain in FY23 as well. Reportedly, more than Rs1trn of tenders have been issued in July 2022 alone. Roads, water, and railways continue to be the major contributors for the same.

Among sectors, roads, railways, water and irrigation, and power equipment (Solar EPC) saw strong inflows in April-July 2022. Growth in railways was driven by large wagon orders. Growth in power equipment was driven by solar EPC orders.

Considering the ‘above estimate’ performance of most infrastructure developers, it is evident that the execution may also be improving. It is reasonable to expect that the infrastructure activity may finally be taking off to an acceleration phase.

Inflation expectations ‘anchored’

Reported CPI for July 2022 was at 6.71%, at five month low level. Though, it remained above the RBI upper tolerance band of 6% for 7^th consecutive month. The core inflation-excluding food and fuel segments- came in at 6.04% in July compared to 6.22% in June. Thus a slowdown in inflation rate was primarily driven by food, transportation and communication.

The RBI Governor commented yesterday that “inflation is getting increasingly anchored; has moderated from the peak. Bond yields at the long end are reflecting the anchoring of inflation. Softening of crude and commodity prices is also supportive. Inflation has peaked and is expected to moderate.”

As per the brokerage firm JM Financials, “India’s inflation trajectory is trending downwards while core inflation should be range bound (5.9% - 6.4%) throughout the upcoming festive season before easing meaningfully. But the risk of percolation of high WPI inflation to retail inflation would keep CPI elevated, currently the wedge remains as high as 8.2% and even if July WPI print eases by 50bps, the wedge would still be 8%. Although global supply chains may show early signs of easing, geopolitical issues are far from over and any further escalation would negatively impact crude price and INR. We see Q2FY23 CPI inflation at 6.9% vs RBIs 7.1%, easing inflation would entail a policy action addressing more towards defending
INR than suppressing demand, hence Sep’22 MPC meet should see shallow rate hikes (30bps).”

Borrowing cost and deposit rates rising

As per rating firm CARE Ratings, “Credit offtake had shown an improving trend in the latter half of FY22, which has continued in the first four months of FY23. RBI has been working on reducing the liquidity surplus in the banking system which has been consistently reducing and is currently around the Rs 2 lakh crore mark from Rs 7 lakh crore at the beginning of 2022.”

Weighted average lending rate (WALR) for all banks has risen post RBI hiking the policy rates. Expectations of further policy rate hikes are also prompting certain banks to proactively raise rates. Deposits rates have also witnessed some hikes; though the rise in deposit rates, has been slower than the increase in lending rates.

 The latest episode of global inflation is impacting peoples’ lives in multiple ways, especially in developed countries where the present generation of citizens has not experienced this kind of rise in the cost of living; borrowing cost and challenges in accessing consumer credit. It is of course a significant challenge for the young investors and professional money managers who have been raised in an environment of profligate fiscal policies; abundance of liquidity; near zero cost of borrowing; persistent struggle to mitigate the deflationary pressures and unchallenged US supremacy over global markets and geopolitics. For them all the assumptions that underlined their investment strategies might be falling apart; just like the Dreamliner Titanic.

This episode of inflation and consequent monetary tightening would indubitably prove to be an important life lesson for the young investors and money managers; and go a long way in defining the future investment strategies and market directions.

Besides, there are some other noticeable side effects of the inflationary pressures on the global socio-economic milieu. For example consider the following:

There are several reports indicating that harassed by the rising cost of living and high rentals, many youngsters may be returning to live with their parents; several more may have delayed the decision to leave the parental homes; yet some other who were living alone are moving in with their partners and friends to save on rental and other costs (for example see here). It may be too early to conclude anything, but if this trend sustains we might find it catalyzing some interesting changes in the demographic profiles of many countries; housing market; immigration policies etc.

There is enough anecdotal evidence available to indicate that employees demand higher wages to manage the rising cost of living; but they seldom agree to wage cuts during the deflationary phase. The businesses therefore usually engage in workforce realignment to optimize their wage bill. The senior employees whose actual contribution is stagnating but wages are rising, are invariably replaced by younger employees which cost much less simply due to their lesser vintage. Inflation thus causes higher unemployment in middle and upper tier employees, who are either forced out of the labor market or accept new jobs at much lower wages. The governments however do not have this luxury of letting senior people go. They usually meet the goal by imposing a moratorium on fresh hiring and rationalizing non-wage costs, e.g., travel.

The products’ prices usually do not move in direct proportion to the raw material prices. During raw material inflation the margins of most companies shrink, unless they enjoy significant demand elasticity for their respective products and are able to pass on the entire raw material inflation on to their customers. However, during the raw material price deflation phase, a majority of companies do not pass on the benefit to their customers. This is the phase when most companies, that have survived the inflationary period, see their margins expanding.

As the rate of inflation declines, the prices of consumer goods do not necessarily fall. They just stop rising at a faster rate. Thus, if the wages of households have not risen in line with the rise in the cost of living, the hit to their consumption and/or savings could become structural.

Financial repression is one of the worst impacts of inflation. The savers lose real income while the borrowers get money at much lower real cost. Post inflation this situation is rarely reversed. Neutral real rate is usually the best case in a deflationary period. Positive real rates are not seen to last for any meaningful period.

To control inflation, a variety of fiscal and monetary policies are used by the governments and central banks. Higher interest rates, lower liquidity, higher tariffs to curb demand, subsidies to the poor to augment their income are some of the popular tools used to mitigate inflation and its impact. However, in case of deflation the use of fiscal policies is not very popular; even though in some cases incentives are offered to encourage demand. Withdrawing fiscal subsidies and incentives in the post inflation period however proves to be a serious political challenge. Thus, while the monetary expansion could be moderated in a relatively shorter span of time, the fiscal corrections could take much longer.

 One good thing about the Monsoon season in North India is that this is the season for new crops of fruits from hill states. We get fresh and juicy pears, plums, apples, cherries, peaches etc.; besides, juicier varieties of mangoes like Chausa and Langda. A visit to the fruit market in Gurgaon yesterday however left a little sour taste in my mouth. None of the seasonal fruit was selling at less than Rs100kg. Apples are more than Rs200/kg. Even mangoes are selling at a rate of Rs120-250/kg.

The vendors selling from carts and smaller shops are unhappy as sales are down notably due to higher prices; and a larger than usual quantity of their merchandise is going to waste due to rotting. The consumer is obviously unhappy as even the seasonal fruits are becoming unaffordable for many of them. The importers of fruits from South East Asia and Americas are also not particularly happy as the demand for expensive and exotic fruits is diminishing consistently due to higher prices. I shall make a trip sometime in September to find out how the farmers are feeling about it.

The food and energy inflation has often remained elevated in India for the past many years due to one reason or the other. Erratic weather (poor crop), depreciating currency (imported inflation), higher support prices, and geopolitics (higher energy prices) etc. The core inflation though remained mostly tamed, except for the sharp rise in input prices post Covid.

There is no evidence to suggest any direct correlation between wage inflation, especially farm wages and non-government urban worker wages. Nonetheless, the indicators like consistent decline in household savings rate; rise in demand for currency, rise in household debt, especially credit card outstanding, could be seen as pointers to indicate that wage hikes might not have matched the household inflation.

Notwithstanding the stagflation like conditions and low visibility of any material improvement in near future, we do not see common man protesting on streets in India. The protest, if any, are feeble and rhetorical, mostly by the politicians from opposition parties. The primary reason for this broader acceptance of high inflation, in my view, is the persistence of inflation for decades, with brief periods of relief in between.

Being an economy materially reliant on agriculture (weather) and imports (edible oil, energy, gold, defence equipment, technology) the population and policymakers both have significantly higher tolerance for food and imported inflation. The phrases like “Beyond control” and “Act of God” are often used by all to accept high inflation. The consumers, investors, money managers and policy makers usually do not consider an episode of high inflation as something that may require any structural change in their respective approaches.

However, this has not been the case for many developed economies like the USA, which are witnessing high inflation after a few decades. A large proportion of the current generation of consumers, investors, money managers and policy makers have not seen any episode of high inflation (and consequent higher rates). Their tolerance to inflation is obviously very low and thus their responses could be very strong. A casual chat with some friends in the USA and UK tells me how the common people in these countries are already feeling “devastated”, even after enhanced cash support from the government. The policy makers, investors and money managers also appear panicked and reacting in haste.

Being an investor in Indian assets only, I see no reason for panic. In fact, I find many reasons to feel optimistic about the future of Indian assets and markets. In the past few years many steps have been taken to contain the imported inflation. These steps shall definitely yield positive results in the next 4-5 years. For example—

·         Focus on renewables, biofuels, local electronic, defence and chemical manufacturing, multiple FTAs etc. should either reduce reliance on imports or at least protect from volatility in global prices. The impact of increased self-reliance (import substitution) could reflect in improved trade balance taking pressure off from the Indian currency.

·         Mission scale efforts to improve production and processing of oil seeds, pulses, fruits & vegetables (horticulture) and marine products etc. have already started to show some early results. The situation could improve materially in the next 4-5years.

·         The current war between Russia and Ukraine has emphasized and reinforced the idea of having a more diversified vendor base for the global businesses. We shall definitely see more bilateral agreements (FTAs etc.) between India and other countries, especially the developed countries that relied overwhelmingly on China and Easter Europe for sourcing their manufactured goods.

·         Full operationalization of Dedicated Freight Corridors, development of multiple expressways along with industrial corridors shall improve the logistic infrastructure brining efficiency in supply chain and optimization of cost of productivity.

·         A leap forward has been taken towards INR convertibility by allowing Indian entrepreneurs to settle their cross border trades in INR. This shall in due course ease pressure on the current account and improve the terms of trade for Indian businesses.

In my view, the current phase of volatility and uncertainty in macro factors like inflation and trade deficit etc. is transient. We have successfully travelled from 12-15% inflation range to 4-8% inflation range in the past 3 decades. In the next decade inflation may stabilize in 3-4% range with materially better trade balance, and a stable INR and mostly neutral rates.

The Federal Open Market Committee (FOMC) of the US Federal Reserve decided to hike the benchmark bank rate by 75bps to 1.5% - 1.75% on Wednesday. The Committee also reiterated that the Fed will continue to shrink its balance sheet by US$47.5bn till August 2022 and from September the unwinding will be stepped up by US$95bn/month. The FOMC noted that there is no sign of broader slowdown in the economy, while lowering its GDP growth forecast for 2022 to 1.7% from 2.8% earlier. The FOMC statement reiterated the strong commitment to achieve the 2% inflation target. The Fed Officials projected raising it to 3.4% by year-end, implying another 175 basis points of tightening this year. The projection shows a rate cut in 2024.

In the post meeting press meet, Chairman Powell commented that “Either a 50 basis point or a 75 basis-point increase seems most likely at our next meeting. We will, however, make our decisions meeting by meeting.” The Chairman added that ““It does appear that the US economy is in a strong position, and well positioned to deal with higher interest rates.”

The US markets reacted favorably to the FOMC decision. The benchmark S&P500 ended 1.46% higher and 10yr benchmark yields fell 3% to 3.29%. 

Lately, I have been reading a lot of views and opinions about the likely outcome. There are strong arguments for a long corrective phase in the US Economy, just like Japan witnessed post the fiscal and monetary profligation of the 1970s. This Volckerish view anticipates a hard landing for the US economy; tremors across the world and gradual decoupling of global markets from the US markets. The other, equally stronger view is aggressive Fed hikes and tightening taming inflation but not without material demand destruction (recession) followed by a deflationary cycle. This Greenspanish view implies a soft landing for the US economy, premature end to Fed tightening and restoration of “Fed Put” for quick market revival.

Besides, there are multiple views that completely deny the independence of the US Fed from domestic politics and geopolitics. One view, though not convincing enough, portends that the US Fed will be forced to abandon its tightening stance before the mid-term polls begin in the US. The other view is that the inevitable end of current hostilities between Russia and Ukraine would mark the end of the global supply chain woes, resulting in reversal of cost pushed inflation; and the global central bankers’ focus will return to financial stability and growth.

Honestly, with each page of additional reading my confusion has compounded exponentially. In fact, I am confused, like never before, about the basic economic concepts like interest rates, inflation, free markets etc.

What I studied in school was that “inflation” is the rate of rise in prices of goods and services over a defined period. For example, if I could buy a basket of groceries for Rs1000 in June 2021; and I have to pay Rs1100 for the same basket in June 2022; the rate of annual inflation for June 2022 is 10%. If the same rate of inflation persists, the price I would need to pay for the same basket in June 2023 would be Rs1210.

If my income grows at the same rate during this period, I will continue to buy the same basket and there would be no change in my lifestyle (just for example). If my income does not grow by 10%, I will have to cut my consumption or borrow money to maintain my lifestyle. In the first case, the demand for groceries would fall and the seller will be forced to cut prices and the inflation will come down and I will be able to afford the same basket of groceries after some time. In the second case, the inflation for groceries will not come down as the demand sustains; but the demand for money (credit) will rise resulting in higher price for money (interest rates). This means in a simple environment higher interest rates and higher inflation could have positive correlation and move in tandem.

However, the inflation-interest rate correlation will turn negative if (in the above example) I borrowed money in the year 2021 itself and I cannot make additional borrowing to meet higher cost of groceries. In this case, even if my income grows to match the grocery inflation, I will have to cut my consumption to meet the rise in my interest expense.

This implies that other things remaining the same, and it being a free market economy, the correlation of inflation and interest rates would depend on the extent of extant leverage in the economy.

The situation however gets complicated when the largest consumer and borrower (the government) is in a position to control the price of money (interest rates) and/or goods & services. For example, if the government (or central bank) increases money supplies and also cuts the price of money (interest rate) the consumption demand could become artificially high, resulting in higher consumer price inflation. The problem gets further complicated if the government is able to manipulate the purchasing power of the currency (exchange rate) and thus also artificially contain the consumer inflation.

The present situation in the US, as per my understanding, is like this:

The US Fed has increased the money supply (M2) by more than ~3x in the past 13years; while maintaining the price of money (interest rates) close to zero. The exchange rate of USD (DXY Index) has appreciated by about 25% during this period. The inflation was therefore artificially suppressed for over a decade.

The “shutdown” of the global economy in the wake of the pandemic breakout, made the cheaper money and expensive currency irrelevant as the real goods and services were in short supply. The war in Europe further complicated the situation of goods and services supply.

Now, the US central bank is trying to find a lower demand-supply (price) equilibrium by (a) reducing the money supply; (b) increasing the price of money (to contain the consumption demand) while (c) maintaining the currency exchange rate at high level (to ensure cheaper imports).

The debate now is about the trajectory of (i) consumption demand destruction; and (b) improvement in supply of goods and services. A steep fall in demand and steep improvement in supply chains could normalize the situation without much damage to the basic fabric of the economy. However, if the trajectory is flatter, the pain may linger on for years or may be decades.

The other solution could be to control the consumption and prices of goods and services also (Marxist model). This will obviously destroy the basic fabric of the US economy as it stands today.

Insofar as India is concerned, our situation is fairly simple. We have limited leverage and the government intermittently controls the prices of money as well as goods & services, especially during the period of crisis. We just need to pray to Lord Indra for good rains and pray to Lord Ganpati for giving some sanity to Mr. Putin and Mr. Zelenskyy. If these two prayers are answered favorably, we shall be in a position to decouple from US markets and charter our own course (or find a more favorable benchmark to follow). Rest all is ok.

In its latest meeting (6-8 June’22) the Monetary Policy Committee (MPC) of RBI unanimously decided to hike the policy rates by another 50bps. Last month, the MPC had announced an unscheduled 40bps hike in rates. With this hike, the policy Repo Rate (rate at which RBI lends short term money to banks) is 4.90%; Standing Deposit Rate (rate at which banks can park their surplus funds with RBI) is 4.65%.

In the latest episode of global inflation, ‘climate change’ is one of the key players. It has significantly impacted the supply and demand equilibrium of many commodities and services in a variety of ways. For example—

(a)   Notable changes in weather patterns have adversely impacted the crop production and livestock supply globally, resulting in sustained rise in food prices.

(b)   The global commitment to fight climate change has resulted in a significant rise in investment in clean energy and clean technology; mostly at the expense of investment in conventional energy. Most countries are aiming to achieve ‘zero emission’ in the next 3 to 4 decades. In the transition period, obviously the supplies of conventional energy shall remain constrained for the lack of adequate investment, tilting the scale in favor of higher prices. Sharp surge in coal and crude oil prices (even adjusted for logistic challenges due to Covid) is indicative of this.

(c)    The focus on clean energy and clean technology has resulted in an immediate rise in demand for non-ferrous metals, silicon, rare earths, semiconductors; whereas the additional capacities will come in due case as new investments are committed. Covid may have pushed the capacity building process further by 3 to 4 years. The demand pull inflation in these commodities and products may also sustain for some more time.

(d)   ‘Climate change’ and the efforts to control/reverse the adverse effects of climate change are resulting in significant displacement of labor in many areas, resulting in demographic imbalances besides demand-supply mismatch.

The farmers displaced due to adverse weather conditions due to climate change are struggling to get employment.

The skill requirements for the jobs lost in the ‘carbonized ecosystem’ and jobs being created in the ‘clean ecosystem’ are very different.

As per a recent McKinsey report, to achieve ‘net-zero’ by 2050, the capital spending on physical assets for energy and land-use systems will need to rise by $3.5 trillion per year for the next 30 years to US$9.2trn/year. The cumulative capital spending on physical assets for the net-zero transition between 2021 and 2050 would be about $275 trillion. A net-zero transition would have a significant and often front-loaded effect on demand, capital allocation, costs, and jobs.

The report highlights - (i) The transition would be felt unevenly among sectors, geographies, and communities, resulting in greater challenges for some constituencies than others. Developing countries and fossil fuel-rich regions are more exposed to the net-zero transition compared with other geographies; and (ii) As high-emissions assets are ramped down and low-emissions ones ramped up in the transition, risks include rising energy prices, energy supply volatility, and asset impairment.

The points to ponder, inter alia, are (i) whether the global economy is prepared and willing to tolerate the pain of transition for 20-30 years; or efforts would be made to find a balance by allocating adequate capital to conventional energy and technologies; especially hydrocarbons and food production; and (ii) who will bear the losses as trillions of dollars in extant assets become redundant? 

 “No brainer” or “mo’ brainer”

What should an investor make out of a situation - when the RBI governor makes a public statement, two weeks before a scheduled monetary policy committee (MPC) meeting, asserting that it’s “no brainer” to expect that the committee will hike rates in the meeting? Especially when this assertion comes a day after the government has taken some very effective fiscal measures to control inflation and less than 3 weeks after the RBI had announced an unscheduled rate hike.

To me, at first it sounded like a confident Central Banker in full control of the situation. He exuded confidence that (i) the external situation of India is strong and the RBI shall be able to manage the current account deficit (CAD) comfortably; (ii) the central government might not have to revise the fiscal deficit target projected in FY23BE since revenue collections are strong; (iii) there are clear signs of growth reviving as reflected in rise in imports despite higher prices and strong exports; and (iv) the RBI is in control of the yield curve and INR exchange rates.

However, on second thought, I feel that the RBI is perhaps as perplexed by the current economic situation (global and domestic) as anyone else. In fact the Governor himself admitted that the situation is volatile and dynamic. Till the February 2022 MPC meeting, the Committee assumed that the inflation is transient and there is no need to tighten the policy but the Russia-Ukraine war changed the dynamics and in April 2022 meeting it was decided to (i) withdraw accommodation; and (ii) hike the effective reverse repo rate by 40bps (that immediately lifted overnight rate by 40bps). Within one month the RBI made an unscheduled 40bps hike in Repo Rate, palpably to preempt INR exchange rate slide in view of the imminent US Fed Rate hike.

The question is when so many external variables, which are not under control of RBI, are operating at different levels, having unpredictable impact on the Indian economy, how could the RBI term a future policy decision “no brainer”?

The Governor admitted that for now inflation is top priority and not the growth. The government appears to be in full agreement with this stance of the RBI. The government has recently diverted Rs one trillion of capex (Road and Infrastructure) allocation towards price maintenance to calm fuel prices. The government has also raised export duties on steel and restricted the export of wheat. The government has also taken measures like hike in subsidies on LPG and fertilizers. Reportedly, the government is also considering limiting sugar exports. Higher cotton prices have reportedly hurt textile exports in the past few months. Recently, the government has also extended the free food scheme for 90million households by six months till September 2022.

Juxtaposing all these, I could deduct the following:

(a)   To control prices, the RBI and Government have decided to sacrifice growth. Higher rates may further delay the private investment recovery. This means the supply side constraints may continue to hinder the growth for longer than previously anticipated.

(b)   The measures taken by the government may hit exports and therefore widen the already worrying CAD.

(c)    The Forex reserves are already down by US$50bn in the past six months. Keeping yields lower and INR stable may require more USD selling by RBI, at a time when CAD is vulnerable. Obviously the external situation might not remain as comfortable as the Governor is asserting.

(d)   The primary factors driving the inflation, viz., extreme weather conditions; global supply chain bottlenecks; Russia-Ukraine war; and Sino-US tensions etc. are beyond the control of the RBI and might continue to put inflationary pressures on Indian economy. So it could very well mean marked stagflationary conditions for a wider section of the Indian economy.

In my view, we all lie in a flux and there is nothing which is “no brainer” at this point in time. The situation is too dynamic to predict anything with reasonable certainty.

Presently, there are two diametrical opposite views about the evolving global situation.

As per the first view, there are conspicuous signs of global growth slithering down as the inflation has begun to destroy the demand, except the food for which demand is largely inelastic. In the recent readings of composite leading indicators have expanded for only one fifth of the countries (vs over 90% in April 2022). PMIs for most developed countries are nearing July 2020 levels. The growth engine of the world, i.e., China is stuttering with the latest growth forecasts fading to 3.9 to 4.5%. The monetary tightening by a number of central bankers has already started to show some results. Consequently, the commodity prices have started to cool down and inflationary expectations should ease going forward. It is therefore likely that the present monetary tightening cycle may reverse much earlier than previously forecasted. This view thus assumes a broad status quo on the present global order.

The second view however assumes a radical shift in the global order. As per this view, the extant global order that is characterized by deflation, independent central banks, globalization, minimum government, rising share of corporate profits in GDP, longer cycles and lower volatility is coming to an end. The emerging global order is remarkably different. It shall be characterized by regionalization, larger socialist governments, pricing power with labor and commodity producers, lower corporate share in profit, high real rates and inflation and poor equity returns.

I am struggling to form a view that lies in between these two extremes.

(mo’ brainer (noun): A situation or puzzle or predicament that is more difficult than it at first seemed; the opposite of a "no brainer"; something that requires more than one person (i.e. mo' than one brain) to figure out.)

After US electing a “leftist” Biden to occupy the White House; Germany elected social democrat Olaf Scholz to the office of Chancellor, France reelected left of center Emmanuel Macron (first reelection of a president since 2002); Italy reelected Christian leftist Sergio Mattarella; and now Australia has elected a leftist Anthony Albanese as the prime minister. The ruling right of the center New Democracy party in Greece has been consistently losing support in opinion polls for the elections scheduled to be held in October later this year.

A number of Latin American countries like Chile, Mexico, Argentina, Bolivia, Peru, and Honduras have elected leftist leaders to lead their respective countries. The opinion polls are indicating that Columbia and Brazil are also most likely to elect leftist leaders in the elections to be held in May and October respectively. In Asia, the Chinese communist regime under President Xi Jinping has strengthened its position.

Moreover, to counter the egalitarian agenda of left of center parties, even the right of center parties like conservatives in UK, BJP in India, LDP in Japan and Yemina in Israel are increasingly resorting to socialist agenda to retain power.

The emerging trends clearly indicate that the rising income and wealth inequalities are driving the political narratives globally. Obviously, this narrative will gain further momentum as the monetary corridor tightens further and fiscal constraints begin more pronounced.

The recent cuts in excise duty on transportation fuel announced by the government of India must be viewed from this angle also.

Over the weekend, the finance minister announced a cut of excise duty on petrol (Rs8/ltr ) and diesel (Rs6/ltr) to cool down the inflation and provide relief to the stressed consumers. The finance minister stated that this cut will have a Rs one trillion impact on the central government budget. She also mentioned that the entire Rs one trillion will be met through reduction in Road and Infrastructure Cess (a part of Central excise on transportation fuel). It is pertinent to mention that the cut of Rs5/ltr in petrol and Rs10/ltr in diesel made in November 2021 was also met entirely through reduction in RIC. The November 2021 cut had an infra budget implication of rs1.2trn.

The union government has levied a Road Cess on sale of petrol and diesel in the union budget for FY99 to create a dedicated fund for construction of roads. The fund was later adopted under a law named Central Road Fund (CRF) Act, 2000. In the Finance Act 2018, the cess was rechristened as The Road and Infrastructure Cess (RIC) as the scope of the fund was widened to include infrastructure.

The Road and Infrastructure Cess (RIC) is collected and levied on specified imported goods and on excisable goods as specified in the Sixth schedule of the said Act. The said goods are motor spirit commonly known as petrol and high-speed diesel oil. The objective of RIC is to provide dedicated funds for development and maintenance of National Highways, railway projects, improvement of safety in railways, State and rural roads and other infrastructure.

The reduction in RIC means almost 10% cut in Rs.11.06trn provided for capital expenditure in FY23BE. This is equal to 75% of the allocation made for NHAI in FY23BE.

Obviously, the immediate relief to the poor from inflation is a higher priority than growth. As things stand today, the tighter monetary and fiscal conditions will continue to challenge the growth ecosystem in near future. This implies that supply side challenges that are threatening the global economy may continue to persist till a new growth paradigm emerges. In the meantime, the economic policy will continue to be a constant struggle to avoid stagflation.